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No Jury’s Adjourned

There once was a market condition
Where stock prices were on a mission
To rise ever higher
Like they were on fire
And bears were accused of sedition

Since Friday, however, we’ve learned
That thesis has been overturned
The question at hand
Will stocks now crash land?
Is one where no jury’s adjourned

I know this note is technically about FX markets, but sometimes other areas are the obvious drivers and so must be addressed. And clearly, all eyes remain on the equity markets right now, which means we can’t escape them when considering the dollar. With that as a prelude, yesterday saw another extremely volatile US equity session, with a substantially lower open and then a sharp rebound that resulted in stock prices here higher by more than 2% at the end of the day. As I had suggested yesterday, however, two of the short volatility contracts that had been among the most popular trading strategies for the past two years have now disintegrated after their values fell by more than 80%. Overnight, equity markets had a more mixed response, with not every market following the price action here. For instance, while Japanese stocks eked out a small gain, virtually every APAC market fell further led by China’s nearly 2% decline. Europe is faring a bit better, with most markets higher there, but the gains are modest, averaging around 0.5%, and hardly enough to offset recent declines. And as I type, US equity futures are pointing to another lower opening, something on the order of 1% right now. I highlight this because it is important to understand that markets have not yet found a new equilibrium. In fact, I would be surprised if we go back to that slow steady appreciation of prices any time soon. After all, if central bank behavior is changing, and clearly it is, then the rationale for constantly higher stock prices has likely ended as well. Rather, individual companies will need to demonstrate they are worth the investment, and I assure you, some won’t be able to do so.

So what does this have to do with FX? Well, it means that the FX markets are likely to be shaken out of their doldrums as well. At this point, it is quite clear that my view of dollar strength is in the tiny minority of global analysts. In fact, I read this morning that given the dollar’s early weakness this year, nearly two dozen of those analysts have raised their year-end target price for the euro, with the median expectation now 1.25, up from 1.22 just a month ago. I also know that long euro positions are near record levels on futures exchanges, which implies that the market is massively short dollars. Let me say that I feel much better about my dollar view when taking this new information into account. The combination of a higher volatility environment and an extreme short dollar position seems to me to be a perfect situation for the dollar to turn around and rally. One thing I have learned over the years is that the market is expert at finding the ‘pain trade’, which is defined as the one that will cause the most players the most losses. We saw that recently in the short volatility trade in stocks and I expect we will see it in the dollar as well. And to that end, the dollar, this morning, is higher vs. most of its counterparts.

In the G10, only the yen has outperformed the dollar overnight in what is clearly an ongoing risk-off sentiment. The worst performer in this space has been the pound, which has fallen back below 1.39 and is down nearly 3% in the past week. I have been particularly bearish on the pound relative to the Street and continue to be so. Its recent woes can be attributed to the weaker than expected Halifax Housing Price data (-0.6%, exp +0.2%) released this morning, as well as Monday’s much weaker than expected Services PMI data. But on top of the data has been the ongoing debacle of the Brexit process, where PM May continues to be unable to find a coherent voice with which to negotiate. I maintained early on, and continue to believe, that there will be no transitional deal, that the UK will simply exit the EU and its customs union next March, and that the idea that the BOE is going to raise rates ahead of this occurrence is daft. As it becomes clearer that there is no plan, the BOE will find itself completely unable to address what will almost certainly be rising inflation. The pound has further to fall.

As to the euro, the only notable data this morning was a widely expected decline in German IP in December, but given the volatility of that data, it doesn’t really take the shine off the economy there. The other German news of note was that Chancellor Merkel has reached a tentative deal with the center-left SPD to form a governing coalition, although that deal has yet to be approved by the SPD membership. I am confident it will be approved, but also expect that German leadership in the Eurozone is likely to be somewhat lacking going forward. I understand the hawks on the ECB have become more vocal, and that is certainly why the euro has performed well so far this year, but I continue to look for the Fed to be more aggressive than currently expected and the ECB to be less so, and the dollar to benefit accordingly. This morning’s 0.3% decline in the euro just means the euro has given back about 1.5% since its recent high at 1.2536. That is hardly enough to shake things up, and quite frankly, until we see the Fed actually acting in a more hawkish manner, the euro probably has a bit more upside. But come year-end, I remain confident in my view.

In the EMG bloc, the dollar’s performance has been more mixed. While EMEA currencies have all fallen vs. the dollar, following the euro lower, APAC saw a very different picture. In fact, the leader there has been CNY, which, after a 0.3% rise overnight, has appreciated 4% in the past month. In truth, this is an impressive performance, but one that I am not sure I can ascribe entirely to market forces. While it is possible that demand for renminbi is rising rapidly, it is also entirely possible that the central bank has pushed Chinese companies to repatriate funds in order to give the appearance of robust demand. As with all things China, it is always difficult to tell where the market impact is the driver as opposed to the government impact. But in fairness, most of the rest of APAC currencies also performed well overnight, with only INR falling after the RBI left rates on hold at 6.0%.

Turning to the day’s upcoming events, the only data point is Consumer Credit (exp $20.0B) and unlikely to move the needle. Of more importance is we have four Fed speakers; Kaplan, Dudley, Evans and Williams. Yesterday, Bullard maintained a dovish view by explaining that just because wages were rising, it didn’t mean inflation would follow. Of course, given that has been the entire Fed argument for the past four years, that seems a pretty ironic statement. But I guess when arguing your book, you make whatever case you can. If pushed, I would expect that the equity market has a far less rosy finish today than it did yesterday, and I expect that the dollar will cede some of its overnight gains. Treasury yields rebounded from Monday’s lows, and I expect that this will continue to be the underlying driver of everything for now.